A Stop-Loss Order Can Offer Some Solace for Nervous Investors

With October on Wall Street comes fear of a stock market plunge, a byproduct of the crises-ridden Octobers of 1987, 1989 and 1990.

And rational or not, that fear is prompting some investors to seek protection--especially given the average stock’s hefty 20%-plus gain this year.

One common tool for nervous small shareholders: the “stop-loss” order, a standing order that automatically triggers the sale of a stock if it falls below a particular price.

Unavailable to large institutional investors simply because of the volume of shares that they trade, the stop-loss order has long been used by individual investors to protect against severe losses in a declining market.

But until recently stop-loss orders could generally be issued only for shares trading on the New York or American stock exchanges, not for Nasdaq Stock Market issues. Now some discount brokerages, including Charles Schwab & Co. and San Diego-based Jack White & Co. , allow customers to place stop-loss orders on thousands of Nasdaq issues as well.

Some full-service brokerages also will accept stop-loss orders for certain Nasdaq issues, usually those in which the firms themselves actively trade.

Despite the label, however, the stop-loss order is no guarantee of protection against a significant decline in a stock’s price, especially in a fast-moving market.

Here’s how a stop-loss order works: Say you bought a stock at $30 a share, and the price now is $60. You want to avoid the prospect of giving back most of that gain in a market decline. So you instruct your broker to stop-loss the stock at $52, a 13% decline from the current price.

As long as the price remains above $52, the stop-loss lies dormant. But if at any point the price falls below $52--even for a single trade--the broker is obligated to immediately sell your shares.

But there’s a hitch: The broker offers no guarantee that your shares will fetch a price just under that $52 stop-loss. The price you get will depend on whatever buyers are bidding when your shares hit the market. In a free-falling market it’s not inconceivable that the stock could begin trading at $54, quickly slump to $52 and then trade next at $50--or $2 below your stop-loss. You would be sold out of the stock at $50, or even lower.

“If something frantic happens, stock bids may drop two or three points” immediately, notes Robert Reed, executive vice president at Jack White. And in an outright market crash, of course, that “gapping” in trading prices could be even more severe, as buyers step back and dealers or stock-exchange floor traders mark down bid prices dramatically.

*

Another inherent weakness of stop-loss orders, especially for exchange-listed stocks, is that the exchange-floor “specialists” who direct trading in individual shares know exactly where stop-loss orders are set, because those orders are entered on the specialists’ books.

Some investment pros contend that creates great potential for conflict of interest. The specialists “have their own personal fortunes to protect,” notes Bob Bacarella, money manager at Monetta Financial in Wheaton, Ill.

In theory, specialists can trigger stop-loss orders on their books by bidding the stock price to just under the level where a horde of stop-loss orders are in place. Buying from those sellers at, say, $50, the specialist conceivably could then turn around and sell at $51 if that sudden rush of selling brings in new buyers.

The exchanges say they have rules in place to lessen the potential for such conflicts. At the New York Stock Exchange, for example, an impartial floor official is supposed to review any specialist’s bid price that triggers stop-loss orders.

Rather than risk tipping their hand, some money managers who could use official stop-loss orders say the better strategy is to keep your own stop-loss limits written down, and simply sell when a stock reaches a set price in the market.

Of course, that’s easier for investors who can monitor the market hour-by-hour than for the individuals who don’t find out about a stock’s sudden decline until after the market has closed for the day.

There’s another problem with stop-loss orders, and that’s determining how much of a stock price decline to accept before stopping-out. If you’re merely looking for an insurance policy against a horrendous market decline, you have to be sure not to set the stop-loss price too close to the stock’s current price, to avoid being forced to sell simply because of short-term fluctuations.

Almost any stock can swing 10% or more in price in short periods, even though the fundamentals of the company haven’t changed, experts note.

Some pros advise setting stop-loss prices 15% below a stock’s current price. But even that may be too “tight” a setting, if your gain in the stock is already huge, and you would prefer not to sell unless the market situation is truly crumbling.

*

If nothing else, the exercise of thinking about stop-loss orders should force investors to recall a cardinal rule about investing: You shouldn’t buy any security without first thinking about when you’d sell it, either on the upside or the downside.

A stop-loss price, whether within an official brokerage order or just as a mental note you make in advance, “Gives you backbone as an investor,” says Jeffrey Roberts, portfolio manager at Richmond, Va.-based Trendline Research & Management Corp., which uses in-house stop-loss limits in managing clients’ mutual fund portfolios.

With a stop-loss price, he says, “If things go wrong, you’ve already determined in advance how you’re going to deal with it.”

Especially in the case of stocks or funds that suddenly go against you--perhaps before you’ve even had a chance to make any money--a stop-loss price provides “an unemotional way of saying, ‘I’ve made a mistake’,” Roberts says.

In the stock market, “You can win a lot, win a little, lose a little or lose a lot,” Roberts says. “You just want to eliminate that last one,” which is what stop-loss orders can do.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

How Much Can You Take?

Investors who set “stop-loss” orders to automatically sell falling stocks must be careful to allow room for what could be normal trading swings. A sampling of stocks already down 9% or more from their 1995 highs: *--*

1995 Tues. Drop vs. Stock high close. high Boeing 72 3/8 65 5/8 -9.3% Walt Disney 62 7/8 56 7/8 -9.5% Viacom A 54 1/8 48 -11.3% Wal-Mart 27 5/8 24 1/4 -12.2% General Motors 51 7/8 45 3/8 -12.5% Deere 95 1/4 83 1/4 -12.6% Compaq 54 3/4 47 1/2 -13.2% Alcoa 60 1/4 50 1/2 -16.2% Circuit City 37 1/8 31 -16.5% IBM 114 5/8 94 7/8 -17.2% Microsoft 109 1/4 88 7/8 -18.6%

*--*